Purchasing and renting real estate can be profitable. It can also generate significant tax benefits. However, the Internal Revenue Code limits some of the tax benefits to taxpayers who are not “real estate professionals,” as defined in IRC Section 469(c)(2).

In most circumstances, real estate rental activities are passive activities. The losses from a passive activity can only be deducted from passive income. They cannot be used to offset ordinary income. But, a “real estate professional” can deduct all rental real estate losses without limitation. They can also offset their real estate losses against non-passive income. Therefore, it is important to know what an individual must do to be a “real estate professional.”

Internal Revenue Code Section 469(c)(7), defines a“real estate professional as someone who:

1.    Performs more than one-half of their personal services, performed in trades or businesses during such taxable year, in real property trades or businesses in which they materially participate, and

2.    Performs more than 750 hours of services during the taxable year in real property trades or businesses in which they materially participate.

Unfortunately, meeting these requirements is just the first step. If the taxpayer has more than one rental property, the IRS and state evaluate the time the taxpayer spends on each property individually unless the taxpayer files a statement specifically electing to group the properties. I.R.C. § 469(c)(7)(A)(ii).

The IRS and state will not combine the time each spouse spends on the real estate activity to meet the material participation requirement. Each spouse must materially participate based on their own time spent. This can eliminate the tax benefits for both spouses if neither meets the requirement on their own. I.R.C. § 469(c)(7)(B)(ii). Please look for future blog articles discussing the nuances of the “material participation” requirements.

We encourage you to review the following court decisions for guidance on what it takes to be a “real estate professional” and receive the associated tax benefits.

1.    Harnett v. Comm’r, T.C. Memo. 2011-191.
2.    Bosque v. Comm’r, T.C. Memo. 2011-79.
3.    Perez v. Comm’r, T.C. Memo. 2010-232.

In Scharf v. Comm’r 32 T.C. Memo 1247 (1973) acq, in result, 1974 WL 36031, the United States Tax Court decided, and the IRS had acquiesced to the decision, that a charitable contribution deduction was available for the donation of a building (albeit partially destroyed) to a volunteer fire department for demolition in firefighter training exercises.

Taxpayers and their tax advisors use this case to support a charitable contribution of their home, often a lake home, to a local fire department. The situation usually involves an older home on a very valuable piece of land. The taxpayer enters an agreement with a fire department allowing the department to use the home for training purposes, including destroying the structure. The taxpayer takes a charitable deduction for the contribution to the fire department and then builds a new home on the property.

The state or the IRS can claim that the value of the contribution has been overstated. Their arguments may include:

1. The Appraisal Did Not Properly Calculate the Fair Market Value of the Contribution. Too often, the appraisal simply separates the value of the structure from the value of the land, and then claims the value of the structure as the deductible amount. This rarely represents the Fair Market Value and often results in an excessive value for the contribution.

“[F]air market value” for this purpose “is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts.” Sec. 1.170A–1(c)(2), Income Tax Regs. Restrictions on the property’s use or marketability on the date of the contribution must be taken into account in the determination of fair market value.Rolfs v. C.I.R., 135 T.C. 471, 480-81 (2010)

The state and the IRS want the taxpayer to demonstrate how much a good faith third party would pay for the structure, separate from the land. They may require the appraiser to include the cost of removing the structure from the land, as a third party buyer could not leave the structure in place.

2. The Taxpayer Received Something of Value for the Contribution. The state or the IRS will often claim that the taxpayer is receiving valuable demolition services in exchange for the contribution. They will likely cite the United States Supreme Court decision in United States v. Am. Bar Endowment, 477 U.S. 105, 116, 106 S.Ct. 2426, 91 L.Ed.2d 89 (1986). “The Am. Bar Endowment test examines whether the fair market value of the contributed property exceeded the fair market value of the benefit received by the donor. . . . Instead, we must consider whether the value of the lake house as donated exceeded the value of the demolition services petitioners received.” Rolfs v. C.I.R., 135 T.C. 471, 487-88 (2010). The taxpayer needs to deduct the value of the demolition services from the value of the contribution. This can result in eliminating the charitable deduction as the value of the demolition services can exceed the value of the rights contributed to the fire department.

Contributing a structure to a fire department is valid transaction, but , to be deductible as a charitable contribution, it needs to be done properly and the value of the rights contributed must be supported.

In the early 1980s, there was an almost endless supply of tax shelters promising deductions and credits that produced benefits far in excess of the investor’s contribution. These shelters were not just for wealthy, promoters pushed them on the average income earner as both a great business opportunity and an investment that would more than pay for itself with tax deductions and tax credits. Many of these shelters led to disastrous results for the investors. The transactions had some basis in tax law, but they were so poorly structured, managed, and over valued, that they could not withstand even the slightest IRS scrutiny. Many investors had to repay all the tax benefits, plus penalties and interest, at historically high rates, and were left with a worthless interest in a valueless “business.”

The demand for shelters has not gone away, but the promoters understand that the IRS is on the watch for the abusive shelters. The courts are also watching and have produced many decisions eliminating or reducing the values of these investments. A benefit of these decisions is that the courts are giving us a roadmap to spotting the good investments that will deliver the promised deductions and credits.

One shelter providing tax benefits that can exceed the amount invested is the Historic Preservation Conservation Easement. This usually involves an investor providing funds to rehabilitate a certified historic structure. As part of the rehabilitation, the investment entity grants a conservation easement to a charitable organization for conservation purposes. A common example of this is the “facade easement,” prohibiting anyone from changing the facade of the building. There are many ways this shelter can fail, including not meeting the strict requirements of the Internal Revenue Code Section 170, but the most likely problem will be the valuation of the contribution.

The taxpayer can use a variety of methods to value of the charitable contribution, but a common valuation method is the “before and after” method: comparing the value of the building before the owner granted the easement and the value of the building after the owner granted the easement. The greater the difference, the greater the charitable deduction and the greater the tax benefit, subject to the IRS limitations on charitable deductions. Experienced, qualified, and honest appraisers can, and often do, produce significantly different values. Thus, the IRS will almost always be tempted to challenge the value, unless it is extremely conservative.

To understand more about the IRS challenges to these investments, we encourage you to review the decisions of the various courts in the following cases:

1. Whitehouse Hotel Ltd Partnership v C.I.R, 615 F 3d 321 (5th Cir. 2010)
2. C.I.R v. Simmons 646 F. 3d 6 (D.C. Cir. 2011)
3. Bruzewicz v. U.S., 604 F. Supp. 2d 1197 (N.D. Ill. E.D., 2009)
4. Richmond v. U.S., 669 F. Supp. 578 (E.D. LA., 1988)
5. 1982 East, LLC v. C.I.R, T.C. Memo 2011-84
6. Evans v. C.I.R.., T.C. Memo 2010-207
7. Schneidelman v. C.I.R., T.C. Memo 2010-151

This is the third post in the Collection Options series. This series is dedicated to presenting individuals and businesses with options for dealing with outstanding tax obligations.

Audit Reconsideration. Through audit reconsideration, a taxpayer may get a second chance at an audit. He may have been previously notified of an audit but been unable to deal with the situation. You may see in the taxpayer’s records that the IRS assessment is clearly or at least potentially wrong. To correct this, you can ask the IRS for an audit reconsideration. Even though an assessment has already been made, the IRS has the discretionary authority to abate an assessment of any tax if it is in excess of the taxpayer’s liability.

Reasons for an audit reconsideration
The taxpayer did not appear for the audit;
The taxpayer moved and did not receive the correspondence from the IRS;
The taxpayer has new documentation to present.

Requirements For an Audit Reconsideration
The taxpayer must have filed a tax return;
The assessment remains unpaid or the Service has reversed tax credits that the taxpayer is disputing;
The taxpayer must know which adjustments they are disputing;
The taxpayer must provide additional information not considered during the original examination.

Audit Reconsideration

The audit examination process is one of the procedural safeguards the IRS uses to ensure taxpayers are complying with our voluntary tax system. Being selected for an Internal Revenue Service (IRS) audit examination does not, however, necessarily mean that the taxpayer did not comply, filed his or her return incorrectly, or abused the system. In some cases, an audit examination may even end in a refund to the taxpayer. A practitioner can often help a taxpayer provide the information the IRS needs to substantiate the taxpayer’s position on the tax return.

The IRS conducts audit examinations in two different ways: a “letter” audit or a “field” audit. In a letter audit, the IRS informs a taxpayer, by letter, that the IRS has identified errors in a taxpayer’s return. The letter may ask for more information or propose adjustments to the tax return. As most letter audits are a result of simple mathematical errors or errors matching Form W-2 or Form 1099 information with the information reported on the return, a taxpayer may not need the assistance of a practitioner when handling a letter audit. Even in a letter audit, the taxpayer must make sure he or she communicates in a timely manner to all IRS requests for information.

In a field audit, the IRS assigns a local representative, called a Revenue Agent (Agent), to conduct a thorough examination of a tax return. Taxpayers may choose to hire a practitioner to help with an audit examination if they are feeling pressured or the audit involves complex factual or legal issues. To represent a taxpayer before the IRS, the practitioner must first complete and submit Form 2848, Power of Attorney and Declaration of Representative to the IRS.

When resolving a case in an field audit, the practitioner must be aware that the Agent is the initial finder of facts. This is the Agent’s greatest power. A good presentation of the facts can eliminate an issue at the earliest stages. The Agent will likely ask to conduct an in-person interview with the taxpayer to collect information. In most circumstances, this interview is helpful as it gives the practitioner the chance to stress the important facts and eliminate any misunderstandings. The practitioner should accompany the taxpayer to this interview and supply the Agent with all of the factual and legal information to persuade the Agent to make a favorable determination. The Agent may ask the taxpayer to provide additional information. If this happens, the practitioner should ask the Agent to issue a written information request to both track the course of the examination and verify that the taxpayer is complying with these requests.

If there is a dispute over a legal issue, the practitioner should provide any relevant legal authority which supports the taxpayer’s position. The Agent, however, does not have the authority to act contrary to a stated IRS position. Thus, even if the practitioner presents strong legal arguments, the Agent may still choose to propose an assessment.

In most cases, the statute of limitations for the IRS to assess additional taxes is three years from the date when the taxpayer filed the tax return. Sometimes, during the course of an audit, the time for assessing additional taxes is close to expiring. If the Agent believes he or she will not complete the audit with enough time for the taxpayer to appeal the determination, he or she may ask the taxpayer to voluntarily extend the statute of limitations for assessment. If the taxpayer does not extend the statute of limitations, the Agent will usually issue a final report and assess any additional taxes and penalties based on the information the Agent collected to that point.

Whether to extend the statute of limitations for assessment is a judgment call. If the practitioner is making progress with the Agent in a timely manner, extending the period will most likely be the best decision as it leaves the period open for later adjustments in the taxpayer’s favor. If the Agent is delaying, searching for more adjustments, or simply harassing the taxpayer, the practitioner should ask the Agent to complete the final report so the taxpayer can file an appeal. A practitioner must examine all implications, good and bad, before refusing to sign an extension.

At the end of an examination, the Agent will issue a final report. This final report will show all of the adjustments, and any proposed refund or additional tax and penalty. The Agent should send the “30-day” letter with the final report. The 30-day letter provides a taxpayer 30 days to accept an Agent’s final report or request an appeals hearing, in writing, with the IRS Appeals Office. If the statute of limitations for assessment is about to expire, instead of issuing the 30-day letter, the Agent will issue a Statutory Notice of Deficiency. The Statutory Notice of Deficiency allows the taxpayer to file a petition in United States Tax Court if he or she does not agree with the Agent’s determination.